Owning a rental property in California can provide you with an amazing (relatively) passive income source.
However, the benefits of an investment property must be weighed against the risk that you incur as a property owner.
Fortunately, when it comes to real estate, there is a way to have your cake and eat it too…It is called:
The California Real Estate LLC.
By taking title to your investment property in a California Real Estate LLC, you will be able to protect your personal assets from any claims that happen on the property.
In addition, you will be able to protect your investment property from any claims brought against you that are unrelated to the property.
California is notorious for its high cost of real estate. While not absolute, this can translate in to higher rent prices. In 2016 to 2017 the average cost of rent in San Diego increased by roughly 7.59% and the county wide vacancy rate fell to 3.3%.
So what does that mean? Those who own investment property are greatly reaping the benefits.
According to experienced Southern California Realtor Tricia Hamilton:
“Some of my most successful clients have made the bulk of their money in investment properties. While I help them find the perfect property, I can’t help them protect that property. Without fail, they all understand that there is only so much they can control when leasing out those properties to tenants. So for all of the risks they cannot control they look to insurance and llc protection.“
Benefits of the California Real Estate LLC
In short, the three major benefits of the California real estate LLC are:
A California Real Estate Limited Liability Company (LLC) meets all three criteria and is a very popular choice of business entity for real estate investments. Similar to a corporation, the real estate LLC establishes a line of separation between the assets held in the LLC and your own personal assets.
Similar to a Partnership, the real estate LLC offers pass-through tax benefits and a great deal of flexibility between you and your co-owners (members) in terms of how you participate in the ownership of the LLC.
Asset Protection Provided By a California Real Estate LLC
LLC’s protect the personal assets of its owners from the debts and liabilities of the business.
When done properly, holding your investment real estate in a California LLC will insulate your personal assets from any debts and liabilities arising from your real estate investments.
For example, if someone gets injured on a property you own, you may be sued by the injured party for damages related to his or her injury. If you hold the property in your name and your liability insurance doesn’t completely cover the claim, you can be held personally liable for the remainder of the damages. Your personal assets, such as your home, automobile, and personal bank accounts will be at risk.
However, if you hold the property in an LLC, the injured party will only be able to recover damages from the assets owned by the LLC. Thus, protecting your personal assets.
4 steps to Setting up a California Real Estate LLC
Setting up a California Real Estate LLC is generally cheaper and involves much less paperwork than setting up a corporation. Here are the four simple steps that must be taken to form an LLC to hold your real estate investments in California:
Step 1: Research a Name For Your California Real Estate LLC
If you are setting up an LLC for real estate purposes or any other entrepreneurial endeavor, you will first need to choose a name. This will require you to research existing business names to make sure that your desired name is distinguishable and available to be used.
Step 2: File Your Certificate of Organization
The actual document that forms your LLC is called as a certificate of organization (or articles of organization) and must be filed with the California Secretary of State.
Step 3: Obtain EIN
Once you file your certificate of organization and receive a response from the California Secretary of State, you can apply to receive a Federal Tax Identification Number, also known as an Employer Identification Number (EIN). This will be the number you use, instead of your Social Security Number, when performing tasks such as filing your business’ tax returns, opening business bank accounts and managing payroll.
Step 4: Transfer Property to Your LLC
You must remember that in order to enjoy the liability protection provided by holding your property in an LLC, the property must actually be owned by the LLC. In other words, you can’t simply own property in your own name and then set up an LLC and hope to enjoy limited personal liability.
You must transfer ownership of the property from your name to the LLC. Then you as the owner of the LLC, which owns the property, you will be insulated from any debts and liabilities arising from ownership of that real estate.
Transferring your property to an LLC is usually achieved by filing a quitclaim deed, a general warranty deed, or some other kind of deed to facilitate a transfer of the property from you to your LLC. Otherwise, as you acquire property, it can be directly purchased in the name of your LLC.
Beware some mortgage lenders are reluctant to lend to LLCs. Furthermore, some mortgages contain a “due on sale clause” that may render the balance of your mortgage due immediately when you transfer ownership of the property to the LLC.
So, before facilitating any transfer of property to your LLC, it is important that you first discuss the transaction with your mortgage lender find out if you will face any adverse consequences in doing so.
The Importance of a Real Estate LLC Operating Agreement
While it is easy enough to set up and operate multiple real estate LLCs, it is important that you run each LLCs properly and as its own separate business, otherwise, you may still be exposed to personal liability.
This means keeping the finances of each LLC that you own separate from your personal finances and separate from each other LLC’s finances. But most importantly, it means having a separate operating agreement in place for each LLC that you own.
A Real Estate LLC operating agreement is basically a management agreement you have with the members of your LLC, or with yourself if you happen to be a single-member LLC. It defines, amongst other things:
- Who owns your LLC
- How it’s going to be managed (who’s in charge)
- Each owner’s responsibilities and obligations
- Whether it should be taxed as a partnership or s-corporation
Having a real estate LLC operating agreement for an LLC is not required by law. However, if you file a certificate of organization with the state to establish an LLC, but do not create an operating agreement to define how it is to be managed, it may be viewed as being improperly managed whenever you face litigation or an IRS audit.
This then will expose you to financial liability and civil penalties, and you will have lost the asset protection that you would have otherwise enjoyed.
The Tax Advantages Provide by a California Real Estate LLC
By default, establishing a California Real Estate LLC provides pass-through tax benefits.
In other words, the profits and losses of your LLC will pass through to you and its other members through the issuance of a K-1. Thus, allowing you to avoid being taxed both at the corporate level and at the personal level (double taxation).
If your California Real Estate LLC has only a single member, you are allowed to elect how you want to be taxed. By default, you will be taxed as a sole proprietor. You may, however, elect to be taxed as an S-corporation. Unlike an S-corporation, your LLC will not have to pay transfer tax whenever it sells or transfers ownership of its property.
Multiple California Real Estate LLCs
If you have more than one piece of real estate, you can hold each property in its own separate LLC and treat each as a separate business.
Your personal assets will be protected from any liability arising from the property you own and each individual property will be protected from any liability that may arise from your ownership of other properties.
For example, if you own three different properties and put them all into one LLC, when there is a lawsuit involving any of the three properties, all three properties will be exposed to liability arising from the lawsuit. So, if someone were to be injured on property A, properties B and C will also be exposed to liability from that lawsuit and may potentially be lost to cover the damages.
However, if you put each of the three properties you own in its own LLC and treat each as its own business, each property will be insulated from the liabilities of the others.
So, if a lawsuit arises concerning property A, properties B and C will be insulated from that lawsuit. Likewise, if a lawsuit arises concerning property B, properties A and C will be insulated from that lawsuit, and so will your personal assets.
A Single Tax Return For Multiple California Real Estate LLCs
While you may want to keep each property in its own LLC, you may be put off by the thought of having to file a separate tax return for each real estate LLC that you create. You can get around this by forming a “master” or “holding” LLC. This master LLC will then own each of the other LLCs that you own.
When you structure the ownership of your real estate in this manner, the IRS says that you only have to file a tax return for the master LLC. So, you can own multiple properties, each in its own LLC and segregated from any liabilities arising from the other LLCs, but only have to file a single tax return.
A California Real Estate LLC is an excellent way to protect your personal assets from your real estate investments in the way a corporation would, while enjoying the flexibility and tax advantages of a sole proprietorship or partnership. However, it is essential that your LLC set up and managed properly and that you discuss with your lender any transfer of property to your LLC before you do so.
When considering the use of a California Real Estate LLC to hold your property, it is best that you enlist the assistance of an experienced asset protection attorney ensure that everything is set up properly and that you are protecting your assets as best as you can.